There are a lot of good things you can say about international trade. But it does not, repeat not, do anything to alleviate a shortage of overall demand. Yes, if you liberalize trade countries will export more. But they will also import more. If you're worried about C+I+G+X-M, it's a wash, because X and M rise equally.

He then went on to criticize expansion of free trade, on the grounds that it does nothing to increase jobs. He might be right: job creation was never the argument for free trade. The economic argument for free trade, rather, was income and wealth creation. But let me stop my own exposition and quote from Bob Murphy. I loved his piece, not just for the content, which was full of nice distinctions and strong analysis, but also for his tone.

I have read Krugman's post a few times to make sure I'm not missing something, but I must confess I think he is committing a very basic error. Specifically, he is confusing the Keynesian accounting identity with a causal theory of how changes in one of the variables lead to changes in the other variables.

Later in the piece, Murphy writes:

To make the fallacy crystal clear, we can reverse Krugman's argument. Suppose governments around the world proposed to completely seal their borders and eliminate trade altogether. If Krugman is right, that should have no effect whatsoever on world output, and hence on the amount of workers necessary to produce all those goods and services.

It's true, every country's export sector would be devastated, but this fall in X would be exactly counterbalanced by a fall in M. Or more accurately, the countries with a trade deficit would see their output rise, but the countries with a trade surplus would see their output fall. There is no trade deficit for the world as a whole, so the two effects would cancel across all countries.

Murphy then closes with a nice numerical illustration.

I particularly like the tone Murphy took with a critic who called him a "damn fool." The threaded discussion between them is interesting and, by sticking to the issue and not responding in kind, Murphy got his critic to say he was sorry and to make a major concession. Well done, Bob.

The Keynesian model suggests that mercantilism can help an economy mired in a Depression. Smoot-Hawley was an almost perfect test. You may not care about the stock market, you may (wrongly) think the stock market only affects fat cats. But the deflationary impact of Smoot-Hawley on goods prices was very ominous. It was a very bad sign for the real economy, for working Americans. It meant lower production was on the way, along with fewer jobs. And the markets were right. And Hoover and Keynes were wrong.

If Kim Jong Il conquered China tomorrow, and closed it off from the world economy, the US trade deficit would shrink. But so would our economy.

I have just one correction to Scott's point above. I think he makes an error that Bob Murphy avoids. As Murphy makes clear, the Keynesian model per se does not suggest that mercantilism can help any economy in any situation, depressed or not, unless you take the word "suggest" to mean that one can be misled by an accounting identity into thinking that way. In other words, there is nothing in the Keynesian model per se that would lead to a belief in mercantilism. But it is true that even very smart Keynesians such as Krugman can be misled when they forget to distinguish between models and accounting identities.

Comments and Sharing

Ideologically, I favor free trade. It's my memory, though, that Rhodesia was hugely more prosperous than even in the early years of Mugabe's rule, when it was blockaded by nearly everyone and made huge amounts of stuff which shortly were substituted by Japanese, European, etc. imports. That seems like a counter-example.

Dave Shutz writes:
Rhodesia was hugely more prosperous than even in the early years of Mugabe's rule, when it was blockaded by nearly everyone and made huge amounts of stuff which shortly were substituted by Japanese, European, etc. imports. That seems like a counter-example.

It's not a counterexample. The blockade did make Rhodesia worse off. I don't remember the data but I do remember reading about it at the time. Mugabe was such a thug that he essentially destroyed property rights. To come up with a counterexample to free trade creating wealth, you need to hold other things constant. Mugabe didn't.

Also, Dave, if you want to go beyond ideology as a basis for free trade, which I recommend, see the Encyclopedia pieces on the Econlib site on "Comparative Advantage," "Free Trade," and "Protectionism."

I have just one correction to Scott's point above. I think he makes an error that Bob Murphy avoids. As Murphy makes clear, the Keynesian model per se does not suggest that mercantilism can help any economy in any situation, depressed or not, unless you take the word "suggest" to mean that one can be misled by an accounting identity into thinking that way.

I'm not positive, but I think Scott has in mind one of Krugman's earlier (and longer) posts--which I'm not going to look up right now--where he explained that erecting mild trade barriers can actually help boost world aggregate demand. So Krugman in that argument wasn't pointing to the accounting identity, he was pointing to a Keynesian macro model with sticky wages etc.

The simple Keynesian theory of income determination is that real income equals planned expenditure. It follows from the theory that firms will not produce what they cannot sell.

The income accounting identity is different. It includes unplanned inventory investment as a type of expenditure and profit on that "investment" as a type of income. That means that output always generates a matching expenditure and a matching income.

Krugman is asserting that the main effect of a free trade aggreement will be a decrease in the demand for import competing goods and an expansion in the demand for exports. This will leave total planned expenditure and output unchanged.

If will, of course, raise the productive capacity of the economy. That is what comparative advantage is all about. But actual income is below capacity, being limited by planned expenditure.

Now, if the trade opening hit the capacity constraint for export goods, while adding to already existing excess capacity in import competing industries, so much the worse.

Murphy reverses the scenario (closing trade.) He makes an example of a very trade dependent nation. He doesn't explicitly say it, but assumes that the increase in the demand for import competing products hit a capacity constraint (we starve because we can't grow food.)

In my view, Krugman's error is failing to see that efficiency enhancing change not only raise the productive capacity of the economy, but can also allow a relatively painless reduction in the price level and expansion in the real quantity of money, which does solve the problem of inadequate real demand. (And Krugman always then falls back on his claim that we are in a liquidity trap.)

On the other hand, he asserts that Japan escaped from demand shortage by exports in mid-00's. However, to make matters more complicated, that assertion is based on misreading of data, as I showed here.

This is ridiculous David. You should stop highlighting meanspirited commenters that called Murphy a "damned fool" and instead highlight critical commenters that Murphy completely ignored.

The point is, since trade legislation will ROUGHLY increase X and M in the same amount, and since there's no reason to expect a massive change in C or I in response, it's not a jobs silver bullet. It's a blog post. Does Murphy really think that Krugman thinks X and M rise "equally". This is extremely poor reasoning on Murphy's part. Krugman is aware of the existence of trade deficits. The most obvious interpretation is that he doesn't think there's any good reason to expect X to rise in any way that is considerably in excess of M (so no notable export oriented growth). And while the efficiencies introduced by trade will increase aggregate demand, there's no reason to believe they'll be nearly enough to contribute to near term growth (hence a safe rough approximation of zero change in C and I).

I don't know how Murphy can take that and assume that Krugman is honestly suggesting a perfect balance of trade. The only way not read Krugman that was is if you read Krugman EXTREMELY literally. I see no reasonable justification for taking him that ridiculously literally.

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